How to buy gold and silver – Paper Gold vs Physical Gold

Welcome to Numismatic Traders! Hey, do you want more information on how to buy gold and silver? Did you know that it’s possible to take ownership of gold and silver beyond its physical form and to invest in “paper gold”?  

Previously we delved into the physical elements of gold and silver. Then we looked at what price you should pay for gold and silver. Our knowledge of how to buy gold and silver is growing as we now compare Paper Gold vs. Physical Gold. 

Paper Gold and Silver defined

Paper Gold and Silver are financial instruments (contracts) that are based on the price of gold and silver or certificates or mining shares that gives you indirect exposure to the gold and silver industry. 

Paper Gold and Silver can be seen as a virtual offer on a market that is a hundred times bigger than the physical metals market. 

Examples of paper gold and paper silver:

• Futures contracts;
• Gold and silver certificates;
• Shares in mining companies;
• Exchange Traded Funds (ETFs);
• Exchange Traded Commodities (ETC).

The pros of Paper Gold and Silver

Paper Gold and Silver have the following uses and benefits that make them attractive to investors.

1. Short term trading
   

   Commodities are difficult and costly to change hands quickly due to their physical properties. Just think of the logistical nightmare of moving tons of gold and silver from one place to another. Paper contracts are much easier and cheaper to change hands and thereby speeding up the process of changing ownership. This facilitates the short term trading aspect of precious metals.

2. Speculation
   

   Paper gold and silver are highly liquid as it can be bought and sold just like shares. It is ideal for speculation purposes due to the low transaction costs and ease of transacting on a large and active market. You can trade for 24-hours a day across the globe on the various markets and execute transactions digitally within seconds. The COMEX market is one of the biggest markets in the world.

3. Storage costs
   

   

   Investors that would like to avoid the storage costs of keeping physical bullion safe and secure.

   It is not only the cost of the physical space that is required. There are also other costs that need consideration such as secured vaults, access control and security, transportation and insurance.

   Storage services can be supplied by gold and silver custodians but they come at a price that diminishes the returns on investment.

4. Low capital required
   

   Paper gold and silver are ideal for investors with low capital who cannot afford to buy full ounces of gold and silver. Paper gold like ETF’s is trading at fractions of ounces commonly at 10% of an ounce.

5. Margins

   Investors do not have to provide the full amount of the contract that they are trading in. They only have to provide a fraction of the total value of the contract. This amount of funds required to open a position is called a margin. A margin is the amount of money that you pay to control a futures contract.Below I am giving a basic example of a margin in the gold futures market.

   The typical contract is:
   – Gold 100 oz
   – Silver 5000 oz

   The margin is calculated by:
   
   Volume in Lots x Contract x Market Price divided by
   Leverage

   If you leverage one gold contract (100 oz) of 1:100 at a current spot price of $1,895 and a lot volume of 0.1, you will only be required a margin of $189.5

   This is calculated by: 0.1(lot) x  100 (contract oz) x $1,895 (market price) divided by leverage of 100 = $189.5

   To make a $200 profit and more than double your money the gold price only has to go up by $20 an ounce. But if the gold price drops by the same amount you would get a margin call which is a demand from the broker to pay in more money to keep your contract. If not the position would be closed by the broker by liquidating or selling it.

6. Dividends from owning mining shares
   

   One of the biggest cons of owning physical gold and silver is its inability to generate income streams over and above the capital growth on the investment.

   Other asset classes can generate constant income as follows:

   
   – Real estate – Rent income;

   – Fixed bank deposits – Interest income. At banks in certain countries like in South Africa  you can still earn an interest on the amount in the bank account.

   – Company Shares (stock market) – Dividend income declared to shareholders by profitable companies.By buying gold mining shares you get exposure to the gold industry and indirectly the gold price as well as the ability to receive a dividend income from these mining companies.

   Mining shares are a popular investment choice for investors who are looking for exposure to gold plus also receiving other income. Certain ETFs distribute the dividends among the investors and use this dividend income to buy more gold stocks.

   The risk of buying mining shares is that buying mining shares should be seen as an investment in the management of the business. You are essentially buying a portion of the business and all the various components required for the business to be able to generate a profit from their mining operations. There is a lot to consider here.

7. Spread the risk over several mining companies.
   

   Extracting gold and silver from the earth’s crust is a risky and capital intensive business. It may take years or even decades from the discovery of precious metals to mining and converting it into a profit. Many times these gold mines are situated in politically unstable areas with a lot of negative political influence to deal with. This may be more complicated with meeting race demands by governments like in South Africa that continued with race politics and threats of government Nationalisation. Considering all of the factors it is difficult to choose a mining company to invest in. The investor stands the chance to lose everything in an industry with low-profit margins. It takes specialized knowledge and expertise to make a wise decision.

   Most investors don’t have the time, capital and energy to embark on making this difficult decision. As a result investment funds that trade near the value of the underlying assets have become popular. These funds are passively managed which results in low management fees.

   By investing in a basket of mining shares your risk of losing money is spread over a wide area.

The cons of Paper Gold and Silver

It is clear that there are benefits to investing in paper gold and silver. So what is the problem with not actually possessing the metal you bought? 

1. Counterparty risk
   

   The futures contract market and EFTs are massive. Many people hold the belief that there is more paper being traded and outstanding than what there are physical gold and silver. If there is not enough gold and silver held by Central Banks and Trading Banks for delivery against the paper contracts, real problems emerge when third parties cannot meet their commitments. The paper becomes worthless when counterparties fail on their delivery promise as nobody would want to take the paper up.

2. ETF’s are not backed by physical gold
   

   ETFs are similar to share certificates that are traded between people. Most ETFs roughly follow the price of gold and silver but they are not backed by physical metals and the paper cannot be exchanged for physical gold and silver. If only a small portion of the market insists on converting their ETF shares to cash, no problem. The ETFs can sell a portion of their physical bullion and pay out the cash.In scenarios where many holders would like to redeem their shares like in panic situations, the ETFs would not be able to handle the situation when they do not hold sufficient physical bullion. In case of a default in the futures market, such an ETF may not be able to pay all the holders.

   You do not want to be the person holding the paper, trying to sell it when the day comes when people lose faith in the system and prefer to hold all their investments in physical gold and silver.

3. Price manipulation

   According to sunshineprofits.com ETFs attempts to make the price of its shares trade without a direct connection to the demand for these shares. This is achieved by the price manipulation of ETFs.Sunshineprofits further says that when the demand for ETFs rises sharply, the increase in price is prevented by issuing new shares and backing it with physical gold or some form of a gold derivative like futures contracts. The increased demand is set-off by the increase in the number of shares reducing the price. ETFs conversely will sell a part of its physical holdings and derivatives and with the cash acquire its own shares in instances where the demand for its shares is low. By offering a lower supply the price is being prevented from falling.

   It has been argued that the manipulating of ETFs prices are keeping people away from physical gold with promises to avoid panic and to control the situation of not having all their shares backed by physical gold and silver.

4. Big margins equal big losses

   I have pointed out how easy it is to double your money when trading with margins. The opposite is also applicable in that you can lose large amounts with only small changes to the price of gold and silver when trading with margins. Margin-trading is a specialized skill, that requires years of experience or a lot of luck.

5. Complex structures of paper gold and silver
   

   Exchange Traded Commodities (ETC) track the performance of commodities by holding them physically or via futures and other financial products. An example of an ETC is the SPDR gold shares that are traded on the major stock exchanges and backed by 1/10 oz gold.

   These funds are known to be complex with a series of conflicts of interest by the banks that physically hold the stock and that speculate on a large scale on the gold and silver price – Goldbroker. Many investment gurus’ advice is to never invest in something that you do not understand.

Why invest in Physical Gold and Silver

For centuries gold and silver have been used to store value. History has proven that gold or silver content has been drastically reduced in government coins when empires became poorer and weaker. Today our currencies have no backing at all.

We currently live in a world where the banking system is bankrupt. Reserves that are held by banks are too limited considering their exposure risk. Gold certificates that are issued by banks can hardly be called “safe” when your gold has been issued by the banks as collateral for the banks to grant credit and to hold speculative positions.  If a bank goes under you will lose everything if you only hold bank-issued gold and silver certificates. First, perform your own due diligence before buying gold certificates from banks. By ensuring that you obtain an ownership certificate that specifies your full name along with the bar’s serial numbers you can guarantee that you have full ownership of your gold.

You might argue that banks are normal businesses that could fail. The government will never allow a full-scale meltdown of the banking system. Unfortunately, governments all over the world are also bankrupt and even worse off financially than many banks. We are not talking about some third-world countries with low GDP’s. Developed Nations are crippled by their debt ratios and hardly in any good financial position to bail anyone out.

Governments all over the world are bankrupt due to enormous public spending on National Programs. There is a lot of toxic debt in all sectors if valued at market value on the markets today. Servicing these debts in the future is questionable.

In a situation where the government and banks are insolvent, it is the safest bet to hold your gold and silver outside of the banking system. In your own possession where you have direct access to your physical gold and silver.

The chances that governments are going to be able to reduce their debt are slim. The United States has tried over the past years and failed. As money printing and budget deficits increase, the value of currencies is being destroyed resulting in a surge in gold and silver price.

All the cons of Paper Gold and Silver mentioned earlier can be avoided by ownership of physical gold.

Final thoughts

With Paper Gold and Silver you do get the benefits of exposure to the precious metal market on which it is based. It also has the benefits of being highly liquid with low transaction costs which is ideal for short-term trading. By investing in gold and silver mine shares you get the added benefits of a possible income stream and capital growth, but these are business investments and you must be able to assess the businesses’ risk and quality of management you are investing in.

Physical Gold and Silver gives you peace of mind over the long term that your wealth is safe. In a world where only 1% of the world’s assets are held by gold, obstacles of storing physical gold and silver become minor when more investors decide to go the “safe” route and protect their wealth against the devaluation of currencies.